War's effect on Iran’s battered economy will be 'devastating', with strong signs of regime change

Tehran has been grappling with western sanctions, soaring inflation and currency devaluation

A woman holds an Iranian flag at an anti-US and anti-Israel demonstration in Tehran, Iran. EPA

Iran’s economy will face a hard hit from the war with Israel, as it continues to grapple with western sanctions, high inflation and currency devaluation, analysts say.

Israel made a surprise attack on nuclear sites in Iran on June 13, claiming Tehran was close to developing a nuclear weapon. As the conflict dragged on with tit-for-tat attacks, the US entered it on Saturday, bombing three nuclear facilities in Iran.

“The impact of the continuing war on Iran's economy will be devastating, particularly because the economy has lost its resilience after 14 years of sanctions,” said Mahdi Ghodsi, an economist at The Vienna Institute for International Economic Studies.

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Residents have begun leaving cities such as Tehran, Tabriz and Isfahan, indicating that economic activity and employment have been “severely paralysed across sectors”, he said.

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Capital market reactions are likely to be negative with the stock market currently closed, said Mohammad Farzanegan, professor of Middle East economics at the Centre for Near and Middle Eastern Studies, Philipps-University Marburg in Germany.

“The market is marked by a high degree of uncertainty,” he said. “The war has placed an additional burden on Iran’s foreign trade, which was already strained by sanctions.”

Iran's economy has suffered under the extraneous sanctions reimposed by Washington in 2018 after US President Donald Trump in his previous term removed the US from the Joint Comprehensive Plan of Action nuclear deal.

The sanctions are yet to be lifted. The country is also on the Financial Action Task Force's blacklist.

Iran’s economic growth is forecast to flatline at 0.3 per cent in 2025, down from 3.5 per cent in 2024, according to the International Monetary Fund. It is forecast to expand 1.1 per cent next year, the fund said in April.

The fund also expects Iran’s inflation rate to rise to 43.3 per cent this year, from 32.6 per cent in 2024, before slightly easing to 42.5 per cent next year.

Due to the lorry drivers’ strikes and the Bandar Abbas explosion just before the Israeli attacks, transport may be the most affected sector, according to Mr Ghodsi.

“This disruption is causing severe supply chain bottlenecks and shortages of goods and resources across cities of all sizes,” he said.

“The prices of goods and commodities are likely to surge substantially due to these supply shocks, further accelerating inflation.”

While the government has announced penalties for shopkeepers raising prices, such measures are unlikely to be effective, he added.

“Sanctions have weakened Iran’s economy and eroded the middle class. Real incomes have declined due to inflation, leading to a higher incidence of poverty,” Mr Farzanegan said.

He also said sanctions reduce Iran’s military spending, which “increases vulnerability to external aggression”.

Iran’s military spending fell by 10 per cent in real terms to $7.9 billion last year despite its involvement in regional conflicts and its support for regional proxies, according to the Stockholm International Peace Research Institute (Sipri).

The impact of sanctions on Iran severely limited its capacity to increase spending, Sipri said in an April report.

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Meanwhile, oil revenue have also been affected as a result of disrupted economic activity. While the damage to energy infrastructure by Israeli attacks has not been significant, fear of bombardment has “already driven workers away from the refineries, significantly hampering production”, Mr Ghodsi said.

“Moreover, strikes have damaged parts of Iran’s energy, electricity, and water infrastructure, which poses a serious risk to civilian life. Without basic access to energy, even food preparation becomes a challenge, a scenario that could escalate into a humanitarian catastrophe,” he added.

Currency devaluation

The Iranian rial, which has been devalued significantly in recent months, fell sharply after the first Israeli attack.

“Subsequently, the government imposed restrictive capital controls and supplied foreign currency to the market”, which temporarily supported the rial, Mr Ghodsi said.

The exchange rate on the parallel market was at about 92,250 rials to a dollar at 1.15pm UAE time on June 23, according to Bonbast.com, which gathers live data from Iranian exchanges.

In April, Iran’s currency fell below the psychologically important level of 1,039,000 rials to the US dollar after US President Donald Trump's administration pressed on with its “maximum pressure” campaign against Tehran with a new round of sanctions.

Further currency devaluation is expected, according to Mr Farzanegan.

Mr Ghodsi agreed, adding that the capital controls on the stock exchange and banking sector have so far prevented a financial meltdown and bank runs.

“However, the increasing exodus to neighbouring countries indicates a capital flight in motion. Every time these controls are loosened, the rial nosedives, worsening instability, driving up import prices, and triggering economic shocks,” he said.

'Regime change on the cards'

Mr Ghodsi said the indicators point towards a regime change in Iran. “I believe the early stages of state failure are now emerging. The Islamic Republic is on a slippery slope,” he said.

He cited the Weberian theory with four criteria “indicative of state failure, all of which now apply to Iran”.

They include loss of monopoly on the use of force, erosion of legitimate authority, inability to provide essential public services and inability to engage as a sovereign peer in the international system.

“Given the continuing retaliatory attacks and the involvement of the United States, we are witnessing clear indicators of regime change,” he said.

US Marines guard the Wilshire Federal Building in Los Angeles during an anti-war protest following US and Israel air attacks on Iran. EPA

According to Mr Farzanegan, even if Iran and its government withstand the aggressions, they will need to “significantly revise their economic, political, social, and security agendas”.

“Whether Iran can resist aggressors (Israel and the US) depends not only on its economic conditions but also on factors like internal unity and the extent of rally-around-the-flag effects during invasion,” he said.

Reforms will need to be undertaken. “The immediate priority is to preserve Iran’s territorial integrity and reduce the risk of a civil war instigated by external actors seeking to turn Iran into a failed state. Such a collapse would be the worst possible,” he added.